President Trump’s unconventional approach to governing has many wondering what impact the new administration will have on the economy and international relations.
The S&P 500 reached an all-time high on March 1st. The popular benchmark is up 20% over the past year and more than 250% since the 2009 market lows. These heady gains and political turmoil have investors also wondering if we are in for a big downturn.
The degree to which the President impacts the stock market is questionable. Why? Corporate profits, not politics, have historically been the primary determinant of long-term returns. This reality helps explain the market’s recent impressive gains. As the chart below shows, earnings of S&P 500 companies started to decline in the first quarter of 2015. The strong dollar and collapse in oil prices were largely behind the earnings drought. Profits began to improve in 2016 as oil prices slowly recovered and the dollar stabilized. So while the post-election rally in stock prices may be a reaction to the new administration’s possible pro-business policies, it more likely reflects the generally strong economic backdrop and a profit recovery that was already under way.
While politics may not have much of a long-term impact on stock prices, valuation levels certainly do. Stocks are like any other asset; the initial price paid is the biggest determinant of future returns. While not at bubble levels, U.S. stocks today are no longer cheap. The average stock in the S&P 500 today is trading around 22x forward earnings – above its ten year average of 16x. This is not bubble territory but worrisome nevertheless.
A longer term perspective on stock returns may offer some comfort to investors today. Take a look at the chart above. Over the 71 years ending in 1997, one year stock returns ranged from a +54% to -43%. But for those with a 15 year holding period, the return spread ranged from a much smaller +18% to +1.0%.
The dilemma is that achieving the returns associated with long holding periods requires you to withstand a fair amount of short- term volatility – something that investors are increasingly not very good at.
Consider that back in 1950, the average share of an American company was held for about 6 years. By 2000, thanks to the pressures imparted by a 24x7 news cycle and technology, the average stock was held for less than 6 months. If all this activity resulted in better outcomes, the effort might be warranted but numerous studies show that the less you trade, the better your returns. My favorite study was aimed at determining the behaviors of Fidelity’s best-performing accounts. This research revealed that the star performers had one thing in common: their owners had forgotten about their portfolios altogether.
While completely forgetting about your investments may not be the best approach, the study does highlight the benefits of sticking with a well thought out plan over the long term. If you find recent events particularly unsettling, now is a good time to review your investment strategy to be sure it is still in line with your long-term goals and objectives. If stocks in your account are over-weighted, consider rebalancing back to your original allocation. Be sure you have sufficient cash on hand to fund near-term expenses and then, take a deep breath...and do nothing.